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Energy Deregulation

Corporate Research E-Letter No. 11, April 2001

Energy Deregulation: Lessons from the Golden State

by Mafruza Khan

On April 25 the Federal Energy Regulatory Commission, reversing their previous stance, offered Californians some respite from the energy crisis in their state by imposing broad price controls on electricity sales in California. Under the order, price controls would be triggered only if grid managers declare an emergency because electricity reserves fell to below 7 percent. The decision goes against the Bush administration's position opposing federal intervention in the state's energy market. The caps are to go into effect May 1 and last for a year and should help California save billions of dollars it would otherwise pay to electricity generators that state officials have accused of price gouging. The state's energy crisis, the result of a flawed deregulation effort that has been manipulated by corporations and politicians, should serve as a lesson for the remaining 42 states that are planning to deregulate electricity in the future.

In a few short weeks during the summer of 1996, the California legislature rushed through AB1890, the energy deregulation bill that is now being regarded as a colossal failure by all and blamed for the state's ongoing energy crisis. As one writer comments, "If California's misbegotten electricity deregulation scheme is ever reduced to canvas or film, the artist would have to be some cross between Hieronymus Bosch and Federico Fellini. At one level, it is a surreal story of grossly compounded economic errors, at another, a gruesome morality tale."

It isn't very hard to understand why AB1890 did not work it was based on wrong assumptions, incorrect forecasting and manipulated by corporate executives and politicians. The consequences of the bill - in addition to up to a 46 percent rate hike for consumers, $4.6 billion in taxpayer monies spent by the state to pay for electricity in the spot market, and a backlash on environmental regulations, including a resurgence of nuclear power - remain to be seen (and felt) in the future. It has also led to the largest investor-owned utility bankruptcy filing in history (the third-largest corporate bankruptcy filing ever) by Pacific Gas and Electric Company.

AB1890: LOSERS AND WINNERS

The utilities contend that they are the victims of deregulation, which brought about their financial crisis by allowing wholesale prices to skyrocket and prevented them from passing on the additional costs to consumers by capping retail prices. In reality, according to consumer advocates, lobbyists for the utility companies all but wrote the deregulation bill and company bosses publicly rejoiced when then-Governor Pete Wilson signed the bill. They also spent more than $45 million in 1998 to beat an initiative that would have restored the old system. Consumer advocates criticize the bankruptcy filing pointing out that the utility's parent company has been making huge profits during the crisis through other subsidiaries. "The parent company has $30 billion, much of what it has siphoned out of the utility coffers. It would have bailed the utility out," allege the Foundation for Taxpayer and Consumer Rights. Bankruptcy experts say that Pacific Gas and Electric's creditors will target $4.63 billion the utility transferred to its parent company while receiving no investment in return. The only losers in this entire ordeal are customers.

The other group that milked the bungled deregulation efforts and have been accused of manipulating the market are energy wholesalers. California's Independent System Operator (ISO), which manages the statewide transmission grid, has accused power generators of overcharging Californians by $6.2 billion since last May. The profits of out of state companies like Enron, Duke Energy, Reliant Energy and Dynergy have been at record levels; their stock prices have also soared in the midst of a depressed market. The Federal Energy Regulatory Commission (FERC) has indicated that it may order some refunds because of price gouging by these firms, most of which are headed by major contributors to Bush's various political campaigns. Duke and Dynergy have challenged the authority of the California Public Utilities Commission to investigate whether they deliberately reduced power supplies to drive up prices. California Representative George Radanovich's request for a General Accounting Office study to investigate allegations of price gouging and market manipulation has been granted.

AB1890: IN THEORY AND IN PRACTICE

The advertised charm of deregulation was the promise of lower power rates under the presumption that the state had an enduring surplus of generating capacity. In theory, by breaking up the utility monopolies, i.e., Pacific Gas and Electric, Southern California Edison and San Diego Gas and Electric, the state would foster competition and drive down rates. The utilities were thus required to sell off their power plants to independent generators who would produce power more efficiently, the parent holding companies could expand into other businesses and their utility subsidiaries would become primarily distribution systems. Profits would help pay off billions of dollars in 'stranded costs' poured into the construction of nuclear power plants, alternative energy and pricey natural gas contracts during the eighties. Consumers would get a mandated 10 percent rate reduction and the new rates would be frozen until March 2002 for most customers.

This model was based on a number of assumptions that included excess capacity lasting until 2005. (In 1994 state officials estimated that California had a 30 percent reserve margin in electric supply.) An economic boom led to an energy shortage by mid-1999. There was also a belief that the extremely low mid-1990s price of natural gas the fuel that powers roughly 40 percent of California's electricity generators - would prevail. Instead natural gas prices have quadrupled in the past year and continue to rise. The gas price increases, however, don't come close to explaining the run-up in wholesale electricity rates, which bear no relation to the cost of generation. Natural gas suppliers have also been accused of conspiring to manipulate the supply of natural gas driving up prices and the cities of Los Angeles and Long Beach have sued Southern California Gas Company, San Diego Gas and Electric and other gas companies in relation to these allegations. California also forced its utilities to buy all their power from the now defunct California Power Exchange, a newly formed auction-like marketplace for buyers and sellers that was supposedly intended to reduce collusion in bidding. The arrangement in reality made the whole system so opaque that there was no way for regulators or the public to know even after the fact whether there might have been collusion. State regulators also saw unscrupulous energy brokers set up shop with little regulation in the deregulated environment. (On Top of all this, a prolonged drought in the Northwest dried all the dams and limited the supply of hydroelectric power that was available for California.)

This scheme seemed to work initially and spot rates stayed low while surplus generating capacity remained. But once demand surged while supply remain fixed, the new system raised spot prices and the utilities ended up with an astronomical bill for their purchases. While this much is true, it still does not clear the utility companies of manipulating the situation. The California Public Utility Commission has been trying to determine how much of the utilities' professed $12 billion debt for wholesale power is real and to what extent it is merely an accounting trick in which income, particularly from the sale of power from plants the companies and their subsidiaries own outside California "goes into one corporate pocket even as the other pocket is turned inside out." The issue was highlighted further when in January PG&E Corporation, the parent of Pacific Gas and Electric, won permission from the Federal Energy Regulatory Commission to shield its profits and stockholders from its subsidiary's debt through a corporate restructuring called 'ring fencing.' Meanwhile, Californians are left with a bill of more than $4 billion that Governor Gray Davis has spent buying power on the expensive spot market on behalf of the utilities.

The question then arises as to why Governor Davis spent taxpayer money bailing out the utilities when he could have purchased every power plant in the state for less money. According to some, maybe it was because current and former utility executives are acting as paid consultants to the governor. Or, maybe the governor's decisions are influenced by the $112,258 he received as political contributions from PG&E in 1999 and in the first half of 2000.

ENERGY DEREGULATION: CAN IT EVER WORK

Other issues emerge that are relevant not only for California but also for the rest of the nation considering deregulation of electricity. These include: examining whether deregulation is inherently a bad idea or did California just bungle it up; does California need more plants for producing power and if it does what kind of capacity will be generating the additional power; and finally what are the implications of these events in California.

The first thing that must be understood is that electricity is not like any other commodity and cannot be stored in any significant amounts. Consequently, supply and demand has to be finely balanced by the transmission system. There may be ample supply for most of the day, but when demand spikes, especially on days of extreme temperatures, the price paid for the peak hours can be, and was, astronomical. Everything sold on the spot market for any given period goes at the market-clearing price, which is the highest price paid for that period. In December 2000, wholesale power that had cost an average of $30 per megawatt in the previous year sold at an average of $330 and went up to $1,200 sometimes.

An analysis by the Energy Group at the Tellus Institute, a Boston consulting firm, conclude that "even under the best of circumstances, the deregulation of energy cannot be trusted to deliver on its many promises." They note that some marginal increases in efficiency would occur in an ideal market an unlikely real world situation. Most states cannot expect market prices (determined by the marginal costs of new supplies) to be lower than regulated rates (determined by lower average embedded costs of existing supplies) would have been in the near future, by definition, unless deregulated markets can generate large efficiency improvements that regulated rates cannot. In California's unregulated environment, there is no mechanism to guarantee adequacy and reliability of supply. In theory, when supply is low, new generators will enter the field, but market uncertainties, restrictions to access and other real world constraints hardly ever assure such outcomes. In California, such constraints took the form of price gouging and the emergence of greedy power brokers who manipulated the spot market.

Combined with rising oil and gas prices, which raises the price of all energy, and with the possibility of players who find that gaming the market is much more lucrative than trying to streamline their business for competitive advantage under deregulation, the result would be a huge loss of benefits earned from low embedded costs of existing supplies. In addition, a deregulated environment also offers few incentives to encourage research and development of more environmentally friendly or socially desirable energy sources.

Another recent study by the consulting firm Booz-Allen & Hamilton finds that energy deregulation has caused significant difficulties for most industrial and commercial customers and companies that benefited used experts who understood the emerging energy markets. The study also finds that differences in state regulatory rules concerning wholesale and retail power were a key influence on energy prices. The example that is often cited is the difference between energy deregulation in Pennsylvania and California.

Compared to California's failed experiment with energy deregulation, Pennsylvania's experience has been a fairly positive one, says Sonow Popowski, the official consumer advocate of the state. (For more details check out www.electrichoice.com) Pennsylvania's electric rates were 15 percent higher than the national average before deregulation, they are lower than the national average now. According to a study published earlier this year by the Center for the Advancement of Energy Markets (CAEM), Pennsylvania and New York lead the nation in establishing policies to encourage retail competition in electricity markets. The two states scored the highest, 66 and 64 out of a possible 100 points, in the Retail Energy Deregulation (RED) Index, an annual scorecard of electricity deregulation, developed using a total of 22 weighted criteria, such as whether a state has a deregulation plan, how much of a state's market is open to competition, the percentage of customers that have actually switched to non-utility suppliers, and whether a state has approved safeguards to ensure fair competition between utility and non-utility suppliers. (California ranked 13 with a score of 38, negative scores were assigned to seven states that have explicitly rejected deregulation, 17 states received scores of zero.)

Only time will prove whether Pennsylvania's success prevails in the long run. There are, however, fundamental differences in Pennsylvania's approach to energy deregulation that explains why it is working at least for now. According to the CAEM study, Pennsylvania involved affected parties in the process utilities and suppliers, customers and small businesses, environmentalists, and other stakeholders. The state has a fair generation policy that does not require its utilities to sell their generation plants as part of restructuring and does not prevent utilities from entering into long-term power contracts with suppliers. The spot market accounts for only 15% to 30% of all electricity sold. Pennsylvania started with a generation surplus, continues to have ample supply and expects to have a 25% increase in new generation capacity over the next five years. California has made limited investments in power plants in the last twenty years and supply options are heavily influenced by environmental guidelines. Pennsylvania uses coal, gas and nuclear power to generate electricity. Unlike California, the state also has a reliable transmission infrastructure.

California's experience has served as a message of caution for some states New Mexico, Nevada, Arkansas, Mississippi, Oregon, Montana, and Vermont have all taken a step back from plunging into deregulation. Colorado backed away last year after doing a careful analysis. The most telling argument against deregulation is found in the Golden State itself. A general assumption for deregulation is that publicly owned power systems are not as reliable or well managed as privately owned utilities. But the publicly owned utilities like the Los Angeles Department of Water and Power and the Sacramento Municipal Utility District, which were not covered by the deregulation law, continue to function without any problems during all this and have been selling large amounts of excess power to the state grid. The Los Angeles Department of Water and Power's General Manager, David Freeman, has been making good use of the additional income from the state grid toward retiring his utility's debt. This should suffice as adequate evidence that public managers have been better executives in recent years in California than corporate kingpins who draw seven figure salaries and bonuses.

Finally, the signs are clear that California's energy crisis has precipitated a backlash against environmental concerns in relation to electricity production. While the state is spending $20 million on radio and television advertisements promoting conservation, and two bills creating more than $500 million in conservation initiatives and incentives have been signed, it is also in a great hurry to generate more capacity at any cost. Governor Davis is under pressure to speed up approval for power plant construction by easing environmental restrictions and has urged approval of a controversial plant in Silicon Valley. Attempts to bring mothballed power plants on line is also a source of controversy as plans to refurbish antiquated plants with state-of-the-art technologies are being abandoned in favor of quick retooling. Before the crisis, alternative energy producers (wind, solar, geo-thermal, biomass) produced 30 percent of California's total electricity. With the utilities defaulting on the money owed to alternative power producers, they are currently supplying 20 percent of California's power. Regulations to speed the cleansing of the nation's air and water have become a convenient scapegoat for California's crisis according to Clean Air Trust, a Washington DC-based public interest group.

The story of energy deregulation will unfold over time. The California mess has created two opposite reactions, that deregulation can never work or that it the only solution. Much remains to be learned and understood. But a cautionary approach that has effective checks and controls in place, including federal legislation in the areas of supply reliability and market power, are worth pursuing.

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